September 24, 1998

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Balance Sheet Checklist, Part 1

On Monday in this space, we promised to present a "checklist of sorts" for investor-sleuths seeking to ask all the right questions about a management's various judgment calls on balance sheet accounts. These columns are a far cry from comprehensive; indeed, tomes have been written exclusively on the categories presented here. However, my next few columns should surrender themselves nicely to the printer and may be useful as a handy reference guide to various mechanical balance sheet manipulations whose levers may or may not be pulled by management in any given period.

The idea for this mini-collection stems in part from the writings of CPA/CFA/BMOC Jack T. Ciesielski of the Analyst's Accounting Observer, and more specifically his write-up, "A Tour Guide to 1997 Annual Reports," which documents a "laundry list of judgement items that analysts should examine as they survey the balance sheet and the footnotes." Examining these "soft spots" is largely the purpose of this column as well. The first area we will peruse is not balance sheet-related at all, but nevertheless is open to substantial manipulation.

Revenue Recognition -- This problem is really an age-old (or accounting-old) one. When is a sale a sale? According to the accrual principle (some wags have noted that it sounds like "a cruel principle"), revenue is recognized as soon as "the effort required to generate the sale is substantially complete and there is a reasonable certainty that payment will be received." With language that only attorneys could love -- and in this case accountants as well because it allows more flexibility -- it is fairly evident why there is no strict interpretation of the ruling.

The already muddy waters become even cloudier by virtue of the fact that some (many) manufacturers have deals with their distributors whereby the distributors can return unsold merchandise. In this instance, conservative accounting would dictate that the sale cannot be recorded until the distributor makes a sale. Until this happens, the merchandise has to remain (at least on paper) in inventory. Is revenue recognized at shipment? If so, and this is often the case, the opportunity is always there to ship to customers before they want or need the goods. A good place to look for clues is in the 10K report under "allowance for sale returns" to see whether or not this number has been jumping around at all.

Examine the specifics surrounding the companies that are involved. Do loose internal controls allow for the shipment of merchandise well in advance of scheduled delivery dates, or even partial merchandise shipments? Again, the types of products being sold (or more to the point, not being sold) is extremely relevant, in some instances it's OK for a company to record revenues before it ships inventory. Companies that engage in long-term construction contracts with clients can either wait until the job is completed or opt to record revenues on an installment basis -- known as the "percentage of completion" method.

This approach is used when realization of revenues is based on the evidence that the ultimate proceeds are available and on the consensus that the result is a better measure of periodic income -- that is, it is proven to more adequately satisfy the matching principle. In other words, revenue is generally recognized when (a) the earning process is complete or virtually complete, and (b) an exchange has taken place. Next week we will quickly review the promised balance sheet considerations.

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